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Fair Value Roundtable

O n a quiet Friday in New York—less
than a month after that chaotic Friday when Bear
Stearns’ stock went into a free fall—a panel of
financial reporting experts met with about 200
corporate directors and other stakeholders to
discuss the role of accounting in the market
turmoil that began in August with the collapse of
two Bear Stearns funds. The April 11 meeting was
organized by the Directors Roundtable and
moderated by Michael R. Young of the law firm
Willkie Farr & Gallagher LLP. In addition to
Young, the speakers included FASB Chairman Robert
Herz; Michael Hall, a partner with KPMG LLP;
Gordon Goodman, trading control officer for
Occidental Petroleum Corp.; and Antonio Yanez Jr.,
a partner with Willkie Farr & Gallagher. All
speakers acknowledged that their views are not
necessarily the views of their respective
organizations. The following is an edited
transcript of the discussion.

Dynamic Assests Don't Fit in Passive Vehicles

Robert Herz, FASB chairman

I n securitization accounting,
there’s been in place, as part of the rules, a
device called a qualified special-purpose entity
(QSPE). It basically was a notion that if assets
were placed into a trust, a vehicle, and then
interests were issued out of that vehicle to
various forms of security holders, what are called
beneficial interest holders; basically the form of
that vehicle, that trust, was to collect the
proceeds on the assets and then remit them to
various security holders. They were fairly
passive, and the rules talked about how the powers
would be very limited—entirely specified up
front—and I think that worked for a fair amount of
time.

But I think what we’ve learned in
the last three to five years is in residential
mortgages (also to a certain extent in commercial
mortgage space and some other assets) that these
assets are not passive in nature. Certainly, the
subprime assets that were put into these vehicles
called “Q’s,” with a lot of hindsight, because
they took a lot of management when they went bad
in terms of the servicing or having to restructure
the loans, modify them, do all sorts of workouts.
That clearly was not intended. I think the lesson
learned here is that they were not actually
“Q-able.”

But that’s with a lot of
hindsight. What are we doing? We’re going to kill
Q’s. It doesn’t work, because people just did not
use them for things that were just passive assets
in the dynamic marketplace.

There are very
few passive assets except Treasury bills, and some
people have their doubts about those nowadays
(just a joke!). So that’s one thing that we’re
looking at, and that will probably result in a lot
of the current securitization transactions not
qualifying for sale accounting and remaining on
the balance sheet.

If you do away with the
Q, you’re left with just the regular SPE that
doesn’t get this kind of hallway pass, and the
rules there are called FASB Interpretation no.
46(R). These rules were put in place after Enron
to deal with the problems revealed there. And
these rules basically say “look to whether there’s
a party that has a majority of risk and/or reward
in the entity” and it provides a statistical
approach to doing that based upon the variability
of potential returns of the assets in the vehicle.
And those kind of rules apply to what are now
dubbed “bank conduits” and “structured investment
vehicles.” And I think they’re an OK set of rules.
With the over–optimism of the subprime era, the
calculations that were done on alot of these were
in some cases overoptimistic.

DON’T RELY SOLELY ON MATH A lot of people thought things were OK until
very recently. And so we’re going to have to
re-examine those as well and probably tighten them
up, probably say “just don’t rely solely on these
mathematical techniques.” Also you’re going to
need to have a very good qualitative look at
exactly what’s going on and who the parties are.
It’s been clear in some of these that the bank
sponsor would provide a liquidity backup. Those
were not considered to be particularly risk-prone
until recently when the music stopped, and they
basically became the only bank in town to finance
the assets in these vehicles.

We are
taking a very hard look at all of that and
probably will, in addition to the mathematical
techniques, really tell companies and their
auditors to look much more carefully and
comprehensively at all the arrangements and the
potential arrangements that exist around these
vehicles.

FAIR VALUE If a company has debt securities that are
neither trading nor held to maturity—held to
maturity securities are held at cost—but are
available for sale; they would carry them on their
balance sheet at fair value, but the change in the
fair value from period to period does not go
directly through earnings; it goes through
something else called other comprehensive income,
which is outside of earnings. All of this has been
in place for eons, as have been the rules relating
to down markets. Now herein lies the rub in a down
market—in down markets, obviously things that
you’re carrying on a markto-market basis on your
balance sheet go immediately through earnings.

If it’s carried as available for sale or at
cost, but the value has gone down severely for a
prolonged period, then there’s what’s called an
other-than-temporary impairment, and it has to be
marked down to value at that point through
earnings. In other words, if there’s been an
impairment, you’ve got to get to the new level.
And of course in a down market that’s what you
get. Again, these rules have been in place for
eons and have gone through many down markets.

WHAT’S NEW ABOUT THIS DOWNMARKET? First, there is a much more rigorous
disclosure framework under FASB Statement no. 157,
Fair Value Measurements . FAS 157 did
not require any new items to be carried to fair
value. What it said is, if the existing rules
either require or permit fair value, this is what
you do and this is what you disclose and the
approaches to it. And it’s a much more robust
disclosure framework. So these kinds of things
were going on already, but they weren’t always
disclosed.

Second, there are more assets
now being carried at fair value. That’s because
over the last few years we’ve, largely at the
request of financial institutions, provided what’s
called a fair value election for financial
assets and liabilities . That is, at the
inception of when you buy a financial asset or
enter into one, you can elect to carry that at
fair value and fair value it through earnings. In
fact, that came into place in the beginning of
2007, and many major financial institutions
voluntarily decided to elect fair value for a
number of the classes of their assets and, in some
cases, financial liabilities as well. So there are
more of these on the books of large banks and even
some smaller financial institutions that are now
carried at fair value due to their elections that
began in 2007 before the credit crisis.

Now the third thing that has happened is, of
course, that a number of classes of assets that
start with the subprime assetsdirectly and those
have been securitized and then go up the ladders
through the securities that are backed by these
things through derivatives that are based on the
instruments that are backed by these things.

I wouldn’t say they all fell immediately to
Level 3. I think some of them are in Level 2 and
some of them are at Level 3, or both. The
hierarchy is not a strict hierarchy once you get
out of Level 1. If you can find “an active market”
for an identical item (Level 1), that is clearly
the best view. If you can’t, then the idea is to
come up with the appropriate techniques and data
points to get to the objective, which is what
would be the sale price right now in an orderly
transaction.

That’s another myth about
fair value. People say this is a liquidation
price. Well, the objective is not a liquidation
price in a fire sale. It’s the price you would get
in a reasonable exchange between knowledgeable
parties. Now, that’s often difficult to discern
now. We have a distressed market for a lot of
asset classes and discerning where something is
liquidation or forced liquidation versus a regular
somebody liking the price and buying it. Finding
the right data points is hard and so is doing the
underlying economic analysis because, essentially,
what we’ve got is a bunch of extremely problematic
assets supporting a whole edifice of complex
securities.

PROVIDED AT INVESTORS’ REQUEST It’s a difficult exercise, but it needs to
be done. And the reason it needs to be done is
because investors have, most investors have, quite
clearly told us this is the information they want.
Not exclusively, but if financial assets are going
to be valued, that is the basis on which they want
them valued.

There are a lot of subjective
estimates involved. There are a lot of estimates
involved in other accounting areas. This is not
the first time or first set of assets—even
financial assets—for which modeling techniques and
getting economic underlying data projecting things
have had to be used. For many, many years people
have been doing it. Again, what is new is that
people were caught unaware while the music was
still playing. They had prices from a market—now
they’ve got to do a much more difficult and
intensive analysis. In cases where that is
involved, disclosure becomes extremely important
to the investors as to how those values were
derived if there were ranges around them. And if
the investors think that they’re going to hold to
them and they think that they’re going to recover
and they’re going to get more cash flows than
would be indicated by the current value, they
ought to talk about this as well. To that point,
the SEC a couple weeks ago put out a letter, an
advisory kind of letter, to people saying here’s
the kind of things we would like you to disclose
in MD&A in these kinds of circumstances, which
I think is very useful.

A Practitioner’s View of Accounting and Market
Changes

Michael Hall, partner, KPMG LLP

W hat I’ve seen over the years has
been each time there’s a market event, it’s
usually a call for a change in the accounting. If
you go back to the savings and loan crisis, what
did it change? It changed a lot of accounting
around allowance for loan losses as banks were
wrestling with the underlying reserving for the
loans. It also necessitated changes in internal
controls as clients processed information to get
their arms around what they have. It also started
changes with respect to investment accounting.

This was the beginning of fair value making
its way onto financial statements, where
previously most investments were accounted for on
a cost basis. Then you had a concept of some
investments at fair value marked through P&L,
and maybe those that you’re not sure whether you
should have it at cost or fair value should be
shown as mark to market through equity.

ACCOUNTING BY INTENT It was one of the first times where we began
investment accounting by intent. You intended to
hold it at cost basis if that’s how you managed
your business. Market events after Enron
necessitated more change in accounting for
investments in entities to determine whether you
control those entities or not, and we had FASB
Interpretation no. 46(R), which tried to help
companies understand and come up with a
determination of whether they control these
special-purpose entities. So we had new standards
coming out. And then today we have market events,
and then we have calls for changes in accounting.

When I look at FAS 157 dealing with fair
value, it hasn’t caused a new requirement for fair
value accounting. It really encompasses the whole
balance sheet, not just financial assets. So what
we’ll see over the next year is more concepts of
FAS 157 exit-value pricing being analyzed and
presented on the balance sheet in areas such as
intangible assets, goodwill and trademarks.
Anything that requires a fair value determination
would be under this exit-price concept. So we’re
seeing it in the financial instruments area in a
distressed market now, and then we’re going to see
it again in other areas of the balance sheet over
the next year as companies adopt FAS 157

INTERNATIONAL STANDARDS TO BRING MORE
CHANGES We will see a lot of changes in
securitization accounting in the next year. We’ll
probably have a new FASB standard, and then more
changes in securitization accounting as we move
towards international standards.

The IASB
[International Accounting Standards Board] is also
looking at the financial asset accounting model.
So we have a period of change in front of us in
addition to the market aspects relating to
securitizations. Also in context of consolidation,
we’ll also see changes to that model where today
sometimes the consolidation analysis of structured
investment vehicles and commercial paper conduits
have been really based on a very detailed,
analytical, quantitative judgment. Some of these
judgments were made by a large Monte Carlo system
calculation as to what types of risks a company
had. If consolidation is only based on the risks
and whether you have the majority of the risks, it
depends on how you define what risks are relevant
to the transaction. In some cases, you weren’t
always measuring every risk that was involved.
There were other elements besides the mechanical
calculation, and, if we see changes in FIN 46(R),
we may see a lot of assets coming back onto the
books of sponsors of certain types of vehicles.

Now that won’t be particularly different
from when we look across to Europe and
international accounting standards. They have a
different model, and a lot of the financial
institutions in Europe have certain of their
vehicles and commercial paper conduits
consolidated onto their financial statements. So
our system may not become that different from
where Europeans are today.

Assessing the Quality of Reported Earnings

Gordon Goodman, trading control officer,
Occidental Petroleum Corp.

I s there a real difference in the
quality of earnings that are reported by different
types of companies? If you looked at the income
statements of Enron in the late 1990s and into
2000, most of what they were reporting—half of
what they were reporting—was unrealized. It was
related to mark-to-market or fair value changes.
It didn’t mean that those are not necessarily
interesting pieces of information, but they’re
quite different pieces of information. And what
this really points to is the distinction between
things that are fixed and things that are
floating.

But this has to do with both
pricing—there are fixed prices, and there are
floating prices. It also has to do with temporal
issues: things that have happened in the past and
things that have not yet happened in the future.
And when you look at the question of the
difference in the quality of earnings, I think
there’s a significant difference between the
things that have happened that are realized and
are fixed and the things that have not yet
happened that are unrealized and that are
floating.

NOT COST OR FAIR VALUE, BUT A HYBRID When you look at our current financial
statements, if you pick up an income statement
today, you’re looking at a combination—a hybrid—of
both realized events and numbers and unrealized
events and numbers. And at a glance it’s very,
very difficult for the average investor or
creditor to understand what percentage of the
income that you’re looking at even today is
realized and what percentage is unrealized. The
same is true on the balance sheet. If you looked
at the Enron balance sheet, a significant portion
of the values that you saw reflected in the Enron
balance sheet were unrealized. They were
historical or previous changes at fair value, were
prior periods but had not yet been realized. It
may relate to contracts that stand 20 years into
the future in some cases.

So in thinking
about these questions, what I realized was that it
would be very simple to pull the two apart and
present it in a very clear fashion, transparent
fashion, to investors and creditors. From the
perspective of hard-asset companies, a company
from Main Street in the United States, we can
represent to the average investor and creditor
most of what we’re doing, who we are, with an
income statement showing only our realized values.
We don’t need to incorporate the unrealized values
to show you what’s going on with our company.
That’s not to say that the unrealized events and
the unrealized values aren’t of interest to us.
They are. But we think it would be much clearer to
investors and creditors to be able to see the
realized income in a simple realized income
statement and not have to pull it apart. The same
is true on the balance sheet. We can pretty much
tell you who we are in terms of our balance sheet
by showing you realized values. And we think that
also should be presented in a realized balance
sheet format.

FAIR VALUE— MORE USEFUL WHEN SEPARATE Now if you did these things, and obviously
if you pulled all your unrealized values, your
fair value type relations out of the income
statement, out of the balance sheet, well, as an
investor I would still want to know what’s
happening on the fair value side. And so the
suggestion is that all those calculations be
presented, but separately, in a fair value
statement, showing all the projected income, rises
in changes from fair value from the current
period, all the changes in fair value from prior
periods reflected in basically a fair value
balance sheet, but all that shown separately in a
fair value statement.

Well, since I made
this suggestion a few years ago, there have been
some changes at FASB. And if you look at the
proposed comprehensive income statement, some of
these ideas are now reflected in it. And if you
look at some of the disclosure requirements that
are now being proposed around fair value
measurements, you can get to the structure that
I’ve talked about; but you have to still pull
things apart to be able to see it the way I
described to you. What I think really has happened
in our financial reporting system is that there’s
temporal confusion.

TEMPORAL CONFUSION There’s literally confusion about the timing
of events of when things have happened and when
things will happen. In order to get to a better
place in terms of financial reporting, we need to
clarify that so that when you pick up a financial
statement you have to literally know whether you
are looking at past events, which should be, in my
mind, on the balance sheet.

Are you
looking at present or recent events, which should
be on the income statement? Or are you looking at
future events, which should be on the fair value
statement? This is a modest proposal. So having
talked about the question of dividing things up
between the past, the present, and the future,
let’s talk a little bit about fair value.

If you were to present things separately in a
fair value statement even inside of those events,
those unrealized future events, there’s a
significant difference between things that are
fixed and things that are floating—things that are
hard and things that are soft. And that difference
is discussed a little bit in the idea of the fair
value hierarchy 1, 2, 3. Things that are exactly
the same, identical, Level 1. Things that are
similar or analogous, Level 2. Things where we
don’t have observable market prices, Level 3.

FAIR VALUE FOR FINANCIAL ACTIVITIES, OLD
ACCOUNTING FOR OLD INDUSTRIES I would agree that in terms of measuring
financial activity, fair value is best. In fact,
it’s the only useful way to think about that. But
for companies that are involved in manufacturing
or extraction of minerals, some of the older ideas
around accounting are really quite useful and,
perhaps, would be a better way to think about how
those companies are doing. I would also note that,
if we had made this differentiation between
realized and unrealized values, hard earnings
versus fair value statement presentations, a lot
of the changes that we’re currently seeing for the
financial companies would be relatively minor
events on their income statement, their balance
sheets if those were just realized statements, and
the changes you’d be seeing would be over in what
I call the fair value statement, which are in the
future. Those would be estimates, some of which
are very good, some of which are very hard, some
of which are relatively fixed, but they haven’t
yet occurred.

And I think it would tend to
pull some anxiety down from the kind of changes
we’re seeing in the current marketplace where
those changes flow immediately through the income
statement, flow immediately over to the balance
sheet. I think it would be a more useful way to
think about these as a series of estimates, which
is what fair value calculations really are. Some
of which are very good estimates, but they’re not
yet fixed. Even for something that we know the
value of, like a stock or a bond or a commodity,
until you pull the trigger, until you actually
sell it and close out the transaction, the value
is going to change on a daily basis. Whereas
things that are fixed won’t change any time in the
future.

A Litigator’s
Perspective

Antonio Yanez Jr., partner, Willkie Farr
& Gallagher LLP

F rom a litigation perspective, I see
three key implications flowing from fair value
accounting under FAS 157 and the related
standards. The first is that we are likely to see
an increase in accounting-related litigation. The
second is that the judgment of financial statement
preparers and auditors is going to be front and
center in that litigation. And the third is that
fair value accounting and other trends could bring
to a head a conflict that’s been brewing for some
time between the evolution of financial reporting
on the one hand and our litigation system on the
other.

AN INCREASE IN ACCOUNTING LITIGATION The first implication is the increase in
accounting-related litigation. And let me start by
taking a step back.

Over the past few
years we’ve seen a steady downward trend in
accounting lawsuits (securities class actions that
center on accounting issues). Different
explanations are offered for that trend. Some
people say that Sarbanes-Oxley has wrung
manipulation out of the system. Others focus on
improvements by the accounting profession. But
there’s one factor that just about everyone has
cited in common, and that is the relative absence
of volatility in stock prices over recent years.

Increased volatility is the byproduct of
fair value accounting that is likely to lead to
more litigation. Quarter after quarter, investors
will be getting more information about changes in
the value of certain assets, and they will be in a
position to react to those changes. And as they
do, stock prices will go up and they will go down.
And to the extent stock prices do go down, there
will be those that assert that the stock price
drop was caused by the market having earlier been
misinformed, and they will have an economic
incentive to make those assertions in litigation.

By the way, fair value accounting is not the
only development in accounting and financial
reporting that could lead to more volatility.
Proposals to provide investors with more real-time
information, with more and better forward-looking
information, and other proposals could lead to
increased volatility and increased litigation as
well.

But sticking for the moment with
fair value accounting, the fact of the matter is
that we’re already seeing an increase in
litigation owing to the subprime situation. I saw
a report earlier this week that there were 163
securities class actions filed in 2007. That
represents an almost 50% increase from the number
filed in 2006. And expectations are that the
earlier downward trend has now been reversed.

Now, I’d like to spend just a moment on the
types of allegations being made in the subprime
cases that are going to resonate and that we’re
going to hear in other lawsuits related to fair
value accounting going forward. These include that
write-downs should have been made earlier than
they were, that there was a failure to disclose
exposure to whatever it was that was written down,
that there should have been warnings about the
write-down before the write-down was taken, and
that there was a failure to maintain systems that
would have limited exposure to what was written
down.

I would also add that, depending on
the circumstances, it might not only be
write-downs that are challenged in litigation;
write-ups could be challenged as well. One can
imagine a situation where there is a write-down
that is followed sometime later by a write-up as
asset values increase. And then allegations could
be made that the initial write-down was too big;
that it was a big bath charge or part of some
other manipulation; that the company was taking
the write-down in order to stock away some value
that it might need at some point down the road. So
it’s all aspects of volatility—upward volatility
and downward volatility—that may contribute to an
increase in litigation.

Now, I want to
emphasize that, in saying that litigation is going
to increase, I am not saying defendants are going
to lose more. There are going to be defenses, but
the main point is that an increase in litigation
is likely.

JUDGEMENT OF PREPARERS AND AUDITORS The second litigation implication of fair
value accounting is that the judgment exercised by
financial statement preparers and by auditors is
going to be front and center in litigation. And
it’s going to be front and center from the very
early stages of the lawsuit.

The reason
there’s going to be a focus on judgment has to do
both with FAS 157 and with more general trends in
accounting and financial reporting. As to FAS 157,
there’s obviously not a lot of judgment in a Level
1 valuation. A market price for an identical asset
is what it is. But there is judgment in Level 2
and Level 3 valuations. For example, there is
judgment in determining whether markets are
sufficiently analogous in making a Level 2
valuation. And there’s obviously judgment involved
in building valuation models in Level 3
situations.

These types of judgment calls,
like all judgment calls, can be second-guessed.
And they will be second-guessed aggressively. The
basic allegation could be that a write–down should
have been made earlier than it was. And to support
that allegation, plaintiffs might assert, for
example, in a Level 2 case that markets considered
to be analogous for valuation purposes in fact
weren’t analogous enough to yield a fair
valuation. In a Level 3 case, plaintiffs could
argue that models were based on improper
assumptions or that they had improper inputs or
that they were poorly constructed and so on.

And this focus on judgment is only going to be
heightened given more general trends. As
accounting and financial reporting move more
towards principles—which require the use of
judgment—so, too, will accounting and financial
reporting litigation focus increasingly on
judgment.

Now, as to why the focus on
judgment will begin from the early stages of the
litigation, that has to do with recent Supreme
Court precedent. In a securities case decided just
last year—the lawyers in the room will recognize
that I’m talking about the Tellabs
case—the Supreme Court basically held that,
before a securities case can get to discovery, a
court must weigh the allegations in the complaint
and come to a view as to whether they suggest
fraud or the absence of fraud. Where the
suggestion of fraud is at least as strong as the
absence of fraud, the case goes forward. Otherwise
it doesn’t.

What that means in fair value,
and for that matter all other accounting-related
securities lawsuits, is that courts at the outset
will be called upon to consider the accounting
judgments that were made in connection with
whatever accounting is being challenged; and
courts will have to come to a view early on in the
lawsuit whether it appears from the facts as
presented in the complaint that the accounting
judgments were tainted by fraud or whether they
appear to have been made in good faith—that is
whether the facts suggest that absence of fraud.

Now here, too, I want to emphasize that this
focus on judgment isn’t necessarily a bad thing
for defendants. Pointing to good judgment
exercised in good faith can be very effective with
juries. It can be a very good defense, but that
judgment is going to be questioned.

CONFLICT BETWEEN FINANCIAL REPORTING AND
LITIGATION That, finally, brings me to the third
implication of fair value accounting, and that is
that fair value accounting—as well as the trend
toward principles and other trends—really bring to
a head the conflict that I mentioned earlier
between the evolution of financial reporting on
the one hand and our system of litigation on the
other.

Fair value accounting is one aspect
of an evolution in financial reporting which seeks
to give financial information users more timely
and more useful information. It is intended as an
improvement. At the same time, our system of
litigation will permit plaintiffs to second-guess
the judgments that are made in developing that
information, and you’ve heard me say that will
result in more litigation overall.

Now,
you’ve also heard me say that more litigation
doesn’t necessarily mean more defense losses and
that the focus on judgment isn’t necessarily a bad
thing from a defense perspective. But the fact
remains hat the process of litigating is painful.
It is expensive, and it is disruptive even if you
end up winning at the end of the day.

So
there’s the conflict. On the one hand, we’re
seeing an evolution in financial reporting that’s
intended to benefit the users of financial
information. But on the other, given our system of
litigation, that evolution will likely result in
more litigation and subjecting those that prepare
financial statements to the pain and expense and
disruption of that litigation even, again, if they
end up winning at the end of the day. And the
question is, is anything going to be done about
that? There have obviously been calls for reform
for some time, but I think that fair value
accounting will bring the need for reform into
focus like never before.

I also want to
mention, just before I conclude, a key player in
all of this that I’ve not mentioned to this point
and that is the SEC and, in particular, the
Commission’s Enforcement Division. How Enforcement
is going to factor fair value accounting into its
program is anybody’s guess. For that matter, what
role the SEC is going to have going forward more
generally is, at least based on the newspapers,
subject to some debate at this point.

But
I will say this. Enforcement has tremendous power
here. We obviously need robust enforcement where
judgments are made in bad faith or without
sufficient inquiry into the underlying facts and
circumstances or otherwise improperly. But if
people are penalized for good faith judgment based
on diligent inquiry—even if somebody can come back
sometime later and say that those judgments were
wrong—the evolution of financial reporting that
I’ve been talking about will be stopped dead in
its tracks. No responsible accountant or auditor
is going to make difficult judgment calls when
doing so could be a career-terminating event.

Audience Q&A

Question: (To Herz) Fair value,
generally, in the broadest sense, where do you see
it going in the future?

Herz: Some nuances might change. I
don’t see it being spread much further beyond
where it is now. We have a conceptual framework
project jointly with the IASB that includes a key
part on measurement attributes in accounting. The
issue goes into various cost models, and cost is
not always objective either. Fair value is one
version of a current value model, but it’s not the
only one. If the IASB makes some tweaks to FAS 157
that make sense, FASB will make the same kind of
tweaks. Most users have urged us, at least in the
financial instruments space, to move to mandatory
full fair value; but I don’t think we’re going to
do that next year.

Question: (To Herz) First, you
mentioned in your talk that the solution of
variable issues in FASB Interpretation no. 46(R)
was an improvement on the standard that was used
at the time of Enron, where Enron gamed the
system. It would appear that FIN 46(R) for many
companies, particularly financial institutions,
was used to game the system as well. How did FASB
allow this to happen?

Second, we have a
tendency in this country to game the system using
accountants, using the financial experts, using
the consultants and work all the way around these
rules. Now we’re moving toward an international
system, where we have to use principles. If we’re
used to gaming the system on the one hand and now
have to move to principles on the other, do we
have the right mind-set for this?

Herz: I think 46(R) was a definite
improvement over the 3% rule that existed before.
The new standard we’re working on is still going
to employ the backstop of calculations, but it is
going to front-end it with some more
characteristics of looking at exactly what’s going
on and to whom. It is actually going to put more
responsibility on the companies and the auditors,
but probably less wiggle room using mathematics
and the like.

We can see from studies
performed after FIN 46(R) was enacted that
hundreds of billions of dollars did go back on
balance sheets and more hundreds of billions of
dollars out of SPEs—in essence the SPEs were
unwound.

In regard to moving toward more
principles, I think the SEC will take up what’s
called a professional judgment framework. It will
have some rigor in it as to what is expected in
exercising a judgment, including what information,
where you got the information, did you consider
the alternatives, did you discuss it, and did you
make choices that were based on trying to give a
good report rather than make the earnings per
share for the quarter?

I’m not an eminent
legal scholar, but there is a belief by some that
if this is put into policy by both the SEC and
adhered to by the PCAOB, including their
enforcement people, that the courts might start to
respect that kind of approach to things. I think
one of the biggest impediments to a lot of
progress in our country is litigation. This is
because everybody is too scared to exercise
reasonable judgment, therefore, they want a rule.
The good people try to comply with the rules, but
the bad people try to use it to structure
transactions around the rules.

Question: (To Young) We just heard
more litigation, more judgments, more potential
stock market volatility. What we haven’t heard is
what do you advise directors to be doing in this
new environment?

Young: If you’re a director, there’s
only so much you can do. There are two things in
particular, though, that directors can do. One is
to set the right tone. Work hard to have the
organization in general, the senior executives and
the accounting staff in particular, to embrace
transparency. The way you get into trouble is not
by making judgment calls. True, there may be more
litigation, but the way you get into trouble is by
distorting judgment calls and not being
transparent about the basis for the judgment call,
which is one reason that FAS 157 is such a
contribution—because you not only put forth the
value, but you put forth the basis for the value.
Then, second, you can encourage your company to
put in place the infrastructure so that the
transparency that should be part of the culture
can be achieved as a matter of logistics.

Online Exclusive Audience Q&A

Question: When you look at the
litigation environment, the costs of
litigation, and the probability that there’d
be increased litigation and we move to a more
a principles-based system, do you think the
capital markets would be better-served by
nationalizing the audit firms and having that
function provided by a federal government
agency?

Young: It is true that there is,
to some extent, a built-in structural
conflict, but it’s hard to think of something
that would work better. In fact, there is a
solution. And we have gone a long way towards
that solution. Fifteen or 20 years ago the
audit was viewed, particularly by senior
executives, as a sort of commodity. Now that
responsibility for oversight of financial
reporting has shifted to the audit committee,
what we are seeing is audit committees
exercising a whole new level of diligence. So
what we actually have happening is the
dissipation of that conflict, because audit
committees are admonishing the auditors to do
a good job and are much less concerned about
the price. And that’s probably a good step in
the right direction.

Question: People speak and refer
to the new securitization rules being made. If
those rules come about, what is that going to
do to bank reserve funds?

Herz: When we develop standards
that impact financial institutions, we talk
with the relevant regulators so they’re part
of these discussions. They’re going to have to
decide what to do, but I think generally
there’s going to be less stuff that qualifies
as sales and more things on the balance sheet.
There will be no such thing as a QSPE. It will
be gone; it will be expunged from the
literature. Regulators are going to have to
decide whether or not they maintain or change
their regulatory capital requirements. We have
our objective of useful reporting to the
investors; they have their objective to safety
and soundness. It’d be nice to always achieve
the two in the same way, but sometimes there
are different perspectives.

Question: Could you address
briefly the rating agencies, where they’ve
been, where they are, and where they think
they’re going?

Goodman: I think what became
obvious to us in the hard-asset industries,
the manufacturing industries, was that the
difficulty of improving your rating if you
were a hard-asset-based company was enormous,
but the difficultly of obtaining a Triple A
rating if you were offering some very exotic
kinds of financial instruments didn’t seem to
be quite as difficult. I’m not sure whether
it’s just proximity. We’re down in Texas, and
the people who are issuing the financial
instruments were up here in New York, but
something’s got to give, and I think there is
some discussion now about differentiating
between the ratings that they give for those
kinds of financial instruments versus the
ratings they give to corporations. We were
very disappointed in their failure to pick up
on some of these issues early on. I published
an article about a year ago about the coming
credit crisis, and I thought it was pretty
obvious that we were about to experience
significant change. My insight was only as
good as the charts I was looking at, but the
charts I saw showed that there was no
probability of default across widely divergent
industries in the United States, which was
absurd. That probability was based on a
pricing the people saw for credit risk. That
had to give. But, for some reason, those kinds
of simple insights didn’t seem to translate to
some of the ratings agencies.

Question: How will the
independent auditor deal with companies that
show low or free assets in excess of their
capital?

Hall: The question was how were
companies dealing with Level 3 assets—with
Level 3 assets being in excess of your
capital. The question could be how that might
come about. In particular it might come about
when you have a company with lots of financial
assets; they have Level 3 inputs. They may
also have liabilities that they’re not marking
to market. Take a company that has sales of
financial assets that they keep on their books
and are accounted for as financings, but they
haven’t availed themselves to fair valuing
their liabilities. So there’s an economic
difference that hasn’t flowed its way to the
financial statements. You may see some
companies having chosen the fair value
election on their liabilities. That’s some of
the economics, but certainly the higher the
level of Level 3 inputs in financial
statements is an area of more audit risk, the
more risk relating to the company, and brings
us into this scenario of questioning the
judgments around the fair value basis.
Ultimately the company’s financial statements
reflect the fair value, but it creates a
greater risk and a greater scrutiny, and
depending on the type of entity we’re talking
about, it is what it is. But again, on the
financial statements, I think if we had a true
fair value measure on both sides, you might
not have that anomaly.

Young : One of the things that an
auditor doing an examination of financial
statements tries to bring is some level of
independence, some level of objectivity. And
there’s actually a new organization to help
auditors do that. It’s called the Center for
Audit Quality. A role of the new Center for
Audit Quality is advising auditors on the
correct approach to those tough kinds of
judgment calls.

Question: I have a question about
the early adoption of FAS 157. Now they’re
saying it’s so bad. Why did they adopt it
early? What was the benefit to adopting it
early?

Hall: Those financial
institutions that adopted went into a lot of
detail why they adopted for certain classes in
their footnotes, and they thought it
better-matched the way they managed their
business. The businesses might involve
financial assets, financial liabilities,
including derivatives. And they felt that fair
valuing certain of them gave a more natural or
economic result. Also, for those that engage
in hedging transactions, it’s a way to not
have to put in all the systems and monitor the
hedges according to FASB Statement no. 133
requirements. And I would suspect that for the
financial assets, they were easier to value.

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